Pension board contention

City appointees must keep problems once solved from resurfacing

Mayor Jerry Sanders appointed Sheffler, a local actuary, to the board of the San Diego City Employees Retirement System for a four-year term that ended in March. Here, he notes some basics of retirement funding and problems with SDCERS.

The city shouldn't skimp on its annual pension contributions

Those who aren't already immersed in actuarial science may find reviewing the basics of retirement-plan funding worthwhile.

The cost of a retirement plan is paid for in installments over the working life of each employee. Each installment is invested and the income from those investments reduces the total cost of his pension to him and the city. This investment-income portion normally amounts to about 80 percent of the total cost of a worker's benefits.

If regular installment payments are not made, the amount of investment income is reduced and the cost of the benefits to the employee and the taxpayers rises. Since the income from investments is added in over a long period of time, the cost of the plan increases exponentially when installment payments are missed. In short, a $100,000 payment skipped today would grow to a $215,000 payment in 10 years.

Many state and local governments have delayed, skipped or reduced payments to their retirement plans. They are usually prohibited from keeping money they should pay into the retirement plan because doing so is considered forced loans from the retirement plan to its state or local government sponsor.

The tragedy is that state and local taxpayers, who ultimately bear the plan's costs, may have to make up not only the missed payments but the interest those payments would have earned had the funds been invested.

In the private sector, the company that sponsors the plan would be subject to severe penalties for skipping or underpaying its contributions. Unfortunately, governments that sponsor retirement plans have traditionally resisted that regulation.

And to their everlasting discredit, public-sector union officials have not seen fit to demand it.

The 'corridor' keeps city payments aligned with reality

Not only skipped payments can affect the city's annual contribution to the pension plan.

Because the investment income that helps pay for the plan varies from year to year, a retirement plan's cost to the city varies, too. To allow the city to budget reasonably for each year's payment, actuaries apply a mathematical process called "smoothing" to prevent ordinary market swings from disrupting typically tight municipal budgets.

Smoothing is not intended, however, to mask extraordinary market changes, whether up or down, or to ignore genuine economic events. So smoothing is limited by a "corridor." In the city retirement system, this corridor is 20 percent of market value, whether it rises or falls.

Without the corridor, the smoothing can artificially decrease the city's payment. At some point, however, the city must catch up.

Let's say the stock market abruptly drops the assets' fair market value to $3 billion when the smoothed value has been set at $4 billion. Given the parameters set by the corridor, the smoothed value must be adjusted to reflect that drop. Otherwise, the loss of investment income won't be included in calculating the city's annual payment, the payment will be too low and future taxpayers will have to fill the gap.

The law requires all private-sector plans to use a corridor because it offers plan participants protection against abuse by the company sponsoring the plan. Public-sector plans aren't required to use them, and many don't. But public plans' trustees cannot excuse their own behavior by pointing out that others do it too. Failing to allow the protection afforded by corridors in public-sector retirement plans is irresponsible.

Trustees elected by unions have a conflict of interest

My last act as an SDCERS trustee was to point out what I must call a breach of fiduciary duty by a fellow trustee, Mark Sullivan, who was elected to represent the Police Officers Association and is now the retirement board's president.

There is a perception that board members elected from union groups like the POA must represent those unions above all other retirees and participants in the city retirement plan. Not so. All board members are supposed to represent all retirees and participants. That's why the Pension Reform Committee recommended entirely eliminating from the board these members elected by city worker unions and retirees.

Instead, the City Council at the time, aware of the financial support of unions during election campaigns, reduced what had been an overwhelming majority of these "elected" members with special interests to a slight minority. All the progress of the last four years can be traced to lessening the power of these elected members on the board, the influence of the unions or group that elected them and the conflicts of interest that arose.

The law calls retirement board members "fiduciaries" and requires certain conduct of them.

The fiduciary relationship is highlighted by good faith, loyalty and trust.

Fiduciaries have a duty to always avoid situations in which personal interests and fiduciary duty conflict. They cannot profit from their fiduciary post without the express knowledge and consent of the people they serve.

And particularly on point:

Even if no improper act results, a conflict of interest exists. And an appearance of impropriety can undermine confidence in the fiduciary who has the conflict or his organization.

These conflicts are insidious. Disregard for their importance led City Hall directly to disastrous plans known as MP1 in 1996 and MP2 in 2002. Board members agreed to a quid pro quo arrangement with unions that let the city pay less than it should have into the pension plan in exchange for more benefits for some members.

The phenomenal absurdity of increasing benefits while reducing contributions got the public's attention, which led to changes in the system.

The conflict shows up most on disability pensions

With overt conflicts of interest exposed as improper, board members must now use more subtle tactics to achieve goals otherwise prevented by law or public outrage. These conflicts most frequently arise in the preferential treatment of public-safety employees' applications for a disability pension.

These actions strike at the heart of fiduciary duty. Members of the retirement board have the same duty to the trust and to all participants, whatever their ties to the groups they were elected to represent. Yet the board's by-laws offer absolutely no opportunity to defeat the "appearance" of a conflict of interest.

How can the public be confident that the city will not again negotiate an informal arrangement with board members elected by their respective special-interest groups?

Unfortunately, Mayor Sanders has refused to reappoint experienced and proven independent trustees (of whom, admittedly, I claim to be one). He can undermine the pension board's independence by trying to barter with elected members or by exercising extraordinary influence over his new appointees.

Moreover, in further attempting to unduly influence the pension board, COO Jay Goldstone has informed the City Council that a committee will study how to circumvent the "corridor." That could easily lead to deliberate shortages in the city's annual contribution to the retirement fund. That's the road to MP3.

In several ways the system is easily ¼gamed'

According to the City Charter, employees are responsible for paying 50 percent of the "normal retirement allowance." Over many years, this requirement has been diluted to the point that employees now pay 19.6 percent of their benefits' cost. Until this year, the city even paid most of that reduced amount.

In city-speak, this is called a "pick-up." By my calculations, in the next two years the employees' contribution will drop to 12.1 percent of the total amount they collect in benefits.

How could that happen?

First, the benefits included in the "normal retirement allowance" haven't been conclusively determined. The list of benefits it does not include, however, has steadily expanded: disability pension payments, any negotiated benefit increases for past service, any losses resulting from plan experience (such as reduced investment income), early retirement subsidies, DROP and death benefits.

Second, when labor negotiations result in improved benefits, the employees are supposed to pay part of the cost of those future benefits. The retirement board is responsible for updating the employees' contribution rates. Again, probably because of the preponderance of "vested" interests on the board, employees have paid no more for future benefits.

Third, employees don't plug several other small leaks in the pension boat. They were undercharged for years for the famous "purchase service credit," but city taxpayers bear the loss.

Then there is pension "gaming," abusive strategies that some departments use to artificially increase workers' pension benefits without paying more into the system.

For example, retirement pensions are based on an employee's highest 12 months' compensation. An employee near retirement gets a temporary promotion and a higher salary, then returns to his previous assignment. But he gets a higher pension as if he had justifiably earned it.

Flaws in San Diego's system an eye-opener for the IRS

The San Diego City Employees Retirement System is much more complicated than the systems of similar cities, meaning more opportunities to exploit loopholes or inconsistencies in the Municipal Code.

In the private sector, retirement systems are designed to defeat many of these abuses. The amount of the employees' contribution is negotiated and their benefits match the funds available. If the fund experiences a series of losses, future benefits are reduced. The employer's contribution cannot be increased without his prior consent.

Until recently, the city code's pension provisions fell far short of the standard of practice in the private sector. The pension board clearly demonstrated that when it submitted the plan to the IRS after the critical Kroll report. The IRS found payments to retirees in excess of lawful limits and plan benefits (and therefore plan assets) diverted to non-participants (the presidential-leave benefit).

Worse, the IRS found that pension funds were raided to pay for health benefits. They have yet to be fully restored.

The SDCERS review so alarmed the IRS that it is now considering a special project to review other public-sector retirement funds.

Active vigilance is the price of a proper system

In summary, continuing issues with the city retirement plan will require active vigilance by citizens. I am most concerned about whether the elected members of the board will act selflessly, as fiduciaries must, and whether the independent trustees on the board can stymie the various attempts by city management or other vested interests to undermine the financial security of the system.

Citizens should be alert to the subtleties of municipal politics and their impact on pension finance. In the past four years, the board made a good start on reforming governance of the plan. But we are a long way from solving the city's pension-funding problems.